Yesterday I wrote about Esther, who earns $89,000 as an employee of Sweet Mountain Magic, Inc. When Esther gets her W-2 at the end of the year, her reported salary is $83,000 instead of $89,000, because $6000 of her earnings went to pay for medical insurance. When Esther prepares her tax return, she fills in $83,000 as her salary income; it´s as though that extra $6000 never existed.
Like employees, self-employed individuals also get a tax break for the purchase of health insurance for themselves, their spouses, and their children (see the definition of "self-employed" at the end of this article). But instead of excluding premiums from gross income as employees do, self-employed people get a deduction. It´s an "above the line" deduction taken on page 1 of Form 1040, so the self-employed person benefits from the deduction even if he doesn´t itemize. This evens up things between the self-employed person and the employee. Right? Well "?¦ not really.
Let´s look at an example. Belén owns an interior design business that has net income of $89,000 for 2006. She pays monthly insurance premiums of $500 to cover herself and her husband, a total of $6000 for the year. By deducting the cost of the premiums, Belén saves $1500 in taxes. On the other hand, Esther, whose salary was exactly the same as Belén´s net income, spent $6000 on medical insurance, just as Belén did; but Esther saved $1959 on her taxes, plus her employer saved an addition $459.
The difference between Esther’s savings and Belén’s is due to social security and Medicare taxes. Belén has to pay them on the $6000 used for insurance premiums. Esther doesn´t. Belén´s income from self-employment shown on Schedule C is still $89,000, and that´s the amount used to calculate Belén´s self-employment tax (the equivalent of Esther´s social security and Medicare). Esther and her employer are $918 better off than Belén.
As if it were not already hard enough for the self-employed to pay for medical insurance, IRS recently stated (Chief Counsel Advice [CCA] 200524001) that if a shareholder of an S corporation purchases an insurance policy in his own name rather than in the corporation´s name, the premiums will not be deductible at all, except as itemized deductions (Schedule A) subject to a floor of 7.5% of adjusted gross income. In some states single-shareholder corporations are not allowed to purchase group policies, so this presents a truly raw deal for some self-employed individuals.
There are things a self-employed person can do to increase their tax benefits for medical expenses. I will look at these next time in Part 3.
Note: for purposes of health care deductions, the self-employed category includes a broader range of businesses than one might expect. In addition to the self-employed individual who reports income and expenses on Schedule C of his or her Form 1040, the following individuals are also considered to be self employed: general partners of a partnership, and limited partners who receive guaranteed payments; members of a limited liability company (LLC) taxed as a partnership or disregarded entity; and shareholders owning more than 2% of an S corporation who received wages or a salary from the corporation.